Leveraging Equity Investments to Build Inclusive Financial Markets
Equity as a funding instrument is particularly important for the responsible development of financial markets. Through purchasing shares in financial services providers (FSPs) and other types of institutions, development finance institutions (DFIs) and social investors have three distinct opportunities to shape market players and in turn influence how markets develop by potentially driving competition, promoting innovation, improving market efficiencies, creating demonstration to crowd-in others and ultimately better serve customers.
Compared to lenders, equity investors can have a substantially wider choice of investees at the starting point, or entry. Because lenders can earn only the margin between their funding cost and the interest and fees determined upfront with the borrower, their investment portfolio is limited to companies with more regular cash flows. In contrast, equity can be placed in start-ups, firms with relatively low revenues now but with strong upside potential later. The higher returns potentially available to equity investors enable them to take more risks and a loss on one investment can, at least theoretically, be offset by the gain on another so long as there is a sizeable investment portfolio.
Equity investors also contribute to these returns by being actively involved in the development and governance of the investee. In contrast, lenders usually can influence a borrower through loan covenants that prevent certain activities or through providing loans that develop others, such as small business lending. Lender influence, however, is defined in the loan conditions and does not change during the life of the loan unless the borrower fails to perform. Through governance, equity investors have the opportunity to build the capacity of the investee and contribute to creating the next generation of leaders in the market.
The investor’s exit decision results in a change of ownership that can potentially change a business’s strategy and how markets develop. A new owner, for example, might have different growth and profitability goals for an FSP that could be hard to reconcile with the nature of serving the bottom of the pyramid segment. Similarly, return expectations can signal what potential buyers should expect and the type of buyers it could attract. Loan repayment, by contrast, does not affect the borrower’s ownership; at most it releases any assets that were used as collateral. Timing considerations are also very different for debt and equity. Lenders require fixed maturity dates that are enforced by debt contracts, while equity investors have at least some flexibility, depending on their funding sources and internal policies, and have to be patient and to try to sell their shares when they have achieved their objectives.